TUTORIAL 1 (10 14 MARCH) ANSWER KEY

Output, Prices
Textbook Reference: Chapter 1
Main Concepts
Gross Domestic Product (GDP)
GDP and Economic Welfare
Prices and inflation
Consumer Price Index (CPI)
Costs of inflation
Biases in measuring inflation
Review Questions
Question 1
(i)

What does GDP measure?

GDP is a measure of the market value of final goods and services produced in a country
during a given period. See BOF, Chapter 1, section 1.2 for greater detail.
(ii)

What are the three methods for calculating GDP?

The expenditure method is the sum of all spending on domestically produced goods less
spending on imported goods.
The income method is the sum of GDP at factor cost and indirect taxes less subsidies. GDP
at factor cost is equal labour income (wages) and capital income (payments to owners of
physical and intangible capital).
The production method or the value added method is the sum of the market value of all
firms product minus their costs. Example Table 1.1 on p.11 of BOF.
(iii)
Why do we add up total expenditure to compute GDP, when GDP is a measure of
production? Why add inventory investment to spending when computing GDP?
Sect. 1.2.4:
Any good or service that is produced will also be purchased by some
economic agent a household or a firm. Goods that are produced in one period but not
sold in that period are termed inventories. By convention, we add the change in inventories
to expenditure as the change in inventories accounts for the difference between what is
produced and what is sold.

(iv)

Is GDP per-capita the same thing as economic welfare?

GDP clearly does not include all the things that people value and all the factors which might
affect peoples level of wellbeing. There are many goods and services that affect economic
welfare but are not priced and sold in the market place and so do not appear in GDP.
(iv)
Identify some factors that are likely to have an impact on economic welfare but are
not measured in GDP.
BOF (Section 1.3) list a number of things that are omitted from GDP but are likely to affect
economic welfare:

Increased leisure time

Non-market (or home) production, markets for illegal goods and the underground
economy

Natural resource depletion and changes in environmental quality

Poverty and economic inequality

Although GDP does not capture all elements of economic welfare, the expectation (hope) is
that increases in real GDP per capita will be positively related to many of the things that
people value. For example, improvements in medicine, health care, life expectancy and
infant mortality all appear to be positively related to increases in GDP.
(v)
Identify some items that you may personally spend money on, but that are not
included in GDP.
Second hand goods, your house, etc.

Question 2
(i)
What does the CPI index measure?
The consumer price index (CPI) is the weighted average market value of a fixed basket of
goods purchased by a typical Australian metropolitan household, relative to its market value
in the base period.
(ii)

How do we calculate the rate of inflation using the CPI index.

Inflation rate as at June 2013

(iii)

Is an increase in the CPI an increase in the cost of living?

CPI measures the cost of living of a typical metropolitan Australian household. There are
many reasons why it may not adequately measure increases in cost of living. These include
but are not limited to:
Not being a typical household, so that the weighting of goods measured do not
reflect that of a particular consumer
The biases mentioned in question 2.
One-off inflation shocks that only affect one or only a few components of the CPI.
Indexed wage adjustments that lead to bracket-creep where every additional dollar
to compensate for inflation is taxed at the consumers highest marginal tax rate.
(iv)

Would a decrease in the CPI lead to a decrease in the cost of living?

The CPI reflects the cost of living of a typical metropolitan Australian household. Even for
this typical household a decrease in the CPI may not decrease the cost of living. For
example, if the price of durable goods fell considerably, and all other goods remained
unchanged, it may not be adequate to suggest a fall in the price of these goods decreases
the cost of living.
(v)

What are the costs of inflation and how may they affect each economic agent.

BOF p.26-29.
(vi)

Which of these costs is likely to be the greatest burden on the economy? Why?

There is an unexpected redistribution of wealth from lenders to borrowers when there is an

increase in the rate of inflation. Since the result is that lenders (savers) are losers, this may
decrease the willingness to save and lend. This would place the greatest burden on the
economy as the borrowing and lending channel is the important for firms that are willing to
borrow to invest in physical capital and create employment and growth in real GDP.

Question 3
YEAR
1

(i)

GOOD
Apples
Bananas
Computers
Apples
Bananas
Computers

PRICE
$4/kg
$2/kg
$2,000
$6/kg
$3/kg
$2,000

QUANTITY
500kg
250kg
3
300kg
400kg
5

From the table above calculate nominal GDP for year 1 and year 2.

(ii)
Calculate the percentage change in the series using both year 1 prices and year 2
prices.
Using year 1 as base year:

Or 41.2%
Using year 2 as the base year:

Or a decrease of 5.45%.
(iii)
Calculate the percentage change in real GDP between years 1 and 2 using your
answers from (ii).
For real GDP we use the chain value method by taking the average of the results in part (ii):
Or 17.87%.
(iv)
If we were to use year 1 as the base year (CPI=100), what is the value of the CPI in
year 2. Calculate the rate of inflation using this figure.
If we use the quantities purchased in year 1 as weights, CPI in year 1 is:

CPI in year 2 is:

The rate of inflation is:

(

Or 12%.
(v)

What biases may render the value found in part (iv) an overstatement?

Quality adjustment bias and substitution bias.

When statisticians fail to adequately adjust for the improvements of the quality of goods
and services, they will tend to overstate inflation. This type of overstatement is called
quality adjustment bias. It is likely that a computer purchased in year 1 is inferior to one
purchased in year 2, yet the prices are the same.
The CPI also fails to adequately account for the substitution between goods when the
relative prices change. The basket weights do not change between periods and hence the
goods are treated as if they were perfect complements. In part (iv), consumers decrease
their consumption of apples since the price of apples has increased by 50%, and increase
their consumption of bananas whose price has only increased by 33%. The index does not
take this substitution into account and hence inflation is overstated.

Discussion Questions
Question 4
(i)
What are the main indicators of macroeconomic performance?
This question is designed to generate some discussion. There are no right or wrong answers;
it really just comes down to individual preferences. Looking at the various indicators of
economic performance, do people think some are more important than others? You could
ask students to rank the six indicators and see if there are some outcomes that are generally
preferred to others.
The textbook (BOF) lists 6 indicators of good macroeconomic performance:
1. Rising Living Standards
Economic growth reflected in broadly continuous increases in the level of GDP per capita
has generally been viewed as a desirable macroeconomic outcome. A lot of effort is directed
at trying to understand the mechanics of economic growth and why some countries are rich
and others are poor. Presumably the hope is to develop policies that will allow poor
countries to increase their levels of GDP and possibly their economic growth rates.
There is an alternative view that continuing economic growth is not a sustainable objective
for the world economy. It argues the limited supply of resources relative to current world
population levels will be a constraint on future growth rates.
2. Relatively Stable Business Cycle
It is desirable to minimize business cycle fluctuations i.e. the deviations of output around
its potential growth path. Booms tend to be inflationary while recessions produce
unemployment.
3. Relatively Stable Prices
One reflection of this goal is the adoption of inflation targets by many countries. Targets for
inflation are often in the range of 1-3 per cent per annum. This suggests that we dont care
about having a completely stable general level of prices, since no-one has a target for
inflation of 0 per cent. There is generally a desire by central banks to avoid deflation (falling
prices). No-one seems to think that deflationary situations (e.g. as in Japan) are a good
macroeconomic outcome.
4. Sustainable Levels of Public and National Debt
The level of public debt (what the government sector owes the private sector) tends to rise
during recessions (as is currently occurring) and also times of national crisis such as wars.
Sustainability is usually taken to mean that a government is expected to be able to run
sufficiently large budget surpluses (tax receipts in excess of expenditures) in the future to
pay-off its current debt.
National debt refers to what the residents of a country (private and public sector) owe the
rest of the world. Sustainability in this case is not an easy concept to define, but one issue

that might be considered is whether the debt is being used to fund investment rather than
consumption spending.
5. A Balance Between Current and Future Spending
The level of national saving and investment will influence the amount of capital
accumulation in an economy and its long-run level of output per capita. If current saving
and investment is too low (or equivalently current consumption is too high) this may have a
cost in terms of lower future capital and living standards (and possibly in terms of lower
future growth).
6. Full Employment
High levels of unemployment are very costly in terms of production foregone, but also in
terms of an unemployed persons welfare.
(ii)
Do you think it is possible to simultaneously achieve good outcomes for all
macroeconomic objectives?
While the previous question lists and explains macroeconomic preferences, this is about
opportunity sets or technical feasibility. It is possible for an economy to achieve good
outcomes for all of these six indicators. The 1960s was a period during which this was
achieved. However this decade may have been an exceptional period.
(iii)

Are there likely to be trade-offs between various objectives? Give some examples.

A classic model in macroeconomics is the Phillips Curve. This predicts a trade-off (at least in
the short-run) between the rate of inflation and the level of unemployment. If you want a
low rate of inflation, there is a cost in terms of having (at least temporarily) a high rate of
unemployment (and vice-versa).

Question 5
Go to the ABS Website at
http://www.rba.gov.au/statistics/tables/index.html#output_labour
(i)
From Table G11, calculate (and record) real GDP (chain volume measure, column
L), consumption (column B), and investment (excluding inventories, sum of columns C, D,
E, and F) for the calendar year 2013.
(Note: The calendar year 2013 corresponds to the sum of quarters March quarter 2013,
June quarter 2013, September quarter 2013, and December quarter 2013 (available 5
March 2014).
G11 GROSS DOMESTIC PRODUCT - EXPENDITURE COMPONENTS
$ million, sa
Chain volume measures
Private spending
Buildings and
Equipment
Other
structures investment investment
investment
Excluding transfers

Household
consumption

Dwelling
investment

Last updated:

06-Mar-14

06-Mar-14

06-Mar-14

06-Mar-14

06-Mar-14

Source

ABS

ABS

ABS

ABS

ABS

Mnemonic

Mar-2013
Jun-2013
Sep-2013
Dec-2013

GGDPECCVPSH GGDPECCVPSD

204136
205371
206764
208386

GGDPECCVPSBSI

17849
18081
18003
18178

34412
34869
35848
35235

824657

Total
Investment

06-Mar-14
ABS

GGDPECCVPSE GGDPECCVPSO

21060
21056
20602
18907

15672
16321
16533
16647

Gross
domestic
product

GGDPECCVGDP

88993
90327
90986
88967

381904
385046
387481
390572

359273

1545003

(ii)
Calculate the consumption share of GDP and investment share of GDP for 2013.
Which component is the largest? Which economic agents conduct consumption spending
and which economic agents conduct investment spending?
Consumption share of GDP = (
Investment share of GDP = (

)
)

BOF p.12 to 15
Consumption is spending by households on goods and services such as food, clothing,
entertainment, transport and housing services.
Investment is spending by firms on final goods and services, primarily capital goods and
housing. The exception is an owner-builder who builds their own home. The use of the
home after construction is considered as consumption.
Note: It should be made clear to students the definition of investment, and does not
include individual investors, which is industry jargon for someone who purchases assets
whether they are real or financial.

(iii)
For each quarter, calculate the percentage changes for the consumption series and
the investment series in part (i) from the quarter December 2003 to the quarter December
2013. Construct a diagram with both series on the same graph.
(see Moodle for excel tips).
G11 GROSS DOMESTIC PRODUCT - EXPENDITURE COMPONENTS
$ million, sa

Household
consumption

Household
consumption
growth

Chain volume measures

Private spending
Dwelling
Buildings and
Equipment
Other
investment structures investment investment
investment
Excluding transfers

Last updated:

06-Mar-14

06-Mar-14

06-Mar-14

06-Mar-14

06-Mar-14

Source

ABS

ABS

ABS

ABS

ABS

Mnemonic

GGDPECCVPSH

GGDPECCVPSD

GGDPECCVPSBSI

Sep-2003
Dec-2003
Mar-2004
Jun-2004
Sep-2004
Dec-2004
Mar-2005
Jun-2005
Sep-2005
Dec-2005
Mar-2006
Jun-2006
Sep-2006
Dec-2006
Mar-2007
Jun-2007
Sep-2007
Dec-2007
Mar-2008
Jun-2008
Sep-2008
Dec-2008
Mar-2009
Jun-2009
Sep-2009
Dec-2009
Mar-2010
Jun-2010
Sep-2010
Dec-2010
Mar-2011
Jun-2011
Sep-2011
Dec-2011
Mar-2012
Jun-2012
Sep-2012
Dec-2012
Mar-2013
Jun-2013
Sep-2013
Dec-2013

151296
154432
156812
158332
160464
162005
162111
164283
165440
166334
167758
169787
171359
173659
177329
178941
181390
184101
184991
183984
183414
182910
183350
185183
185556
187455
188059
190626
192362
194331
195626
196949
197857
198345
201077
201858
202487
203078
204136
205371
206764
208386

2.07
1.54
0.97
1.35
0.96
0.07
1.34
0.70
0.54
0.86
1.21
0.93
1.34
2.11
0.91
1.37
1.49
0.48
-0.54
-0.31
-0.27
0.24
1.00
0.20
1.02
0.32
1.36
0.91
1.02
0.67
0.68
0.46
0.25
1.38
0.39
0.31
0.29
0.52
0.60
0.68
0.78

17076
17999
18644
18395
18322
17952
17646
18522
18172
17604
17022
17833
17157
17577
18018
17739
17602
17744
18157
18265
18430
18020
17543
16739
17532
17946
17770
18327
18384
17900
18289
18558
18247
18091
17795
17409
17587
17935
17849
18081
18003
18178

12249
13084
13158
12948
12700
14029
14282
14878
16048
16803
16594
17637
17253
18576
20137
19872
19902
19186
20665
20936
22312
23121
22465
22582
20315
19907
19489
21513
21447
21590
23371
24106
28691
28317
32679
34543
35373
36817
34412
34869
35848
35235

Total
Investment

Total
Investment
growth

GGDPECCVPSE GGDPECCVPSO

11754
12153
12247
12704
13227
14245
13820
14888
15560
16532
16589
16072
16020
15597
16893
18241
18656
19484
19883
21067
20430
19183
18699
18728
18344
20641
19172
18511
18208
19825
21194
22111
23547
22861
22622
22539
22857
22659
21060
21056
20602
18907

13523
13655
13240
12943
12448
12167
12405
12675
12633
12787
13159
13571
13360
13213
13618
14657
14908
14858
14751
14228
13765
13516
13803
14342
14531
14221
14434
14644
14478
14088
14388
14515
14870
15007
15079
15143
15520
15714
15672
16321
16533
16647

54602
56891
57289
56990
56697
58393
58153
60963
62413
63726
63364
65113
63790
64963
68666
70509
71068
71272
73456
74496
74937
73840
72510
72391
70722
72715
70865
72995
72517
73403
77242
79290
85355
84276
88175
89634
91337
93125
88993
90327
90986
88967

4.19
0.70
-0.52
-0.51
2.99
-0.41
4.83
2.38
2.10
-0.57
2.76
-2.03
1.84
5.70
2.68
0.79
0.29
3.06
1.42
0.59
-1.46
-1.80
-0.16
-2.31
2.82
-2.54
3.01
-0.65
1.22
5.23
2.65
7.65
-1.26
4.63
1.65
1.90
1.96
-4.44
1.50
0.73
-2.22

(iv)
What are the key differences between the two series? Use the definition of
consumption and investment to explain the differences.
There is a clear difference in the variance of the percentage change in either series.
Students with a nascent understanding of statistics may describe this, for example, as
fluctuations that are more prominent.
A good answer should include reasons why consumption is smooth, or does not fluctuate as
much, with reference to the spending included in this measure.